Analyzing a Balance Sheet with Ratios

A balance sheet helps to interpret the financial health of a business. The financial ratios are used by investors and analysts to understand the efficiency and effectiveness of a business. The below-mentioned ratios are crucial for any business.

1. Liquidity Ratios: This shows the amount of liquidity a business can have during times of emergency. Two forms of liquidity ratios are measured: Current Ratio and Quick Ratio.

• Current Ratio: Measured by dividing current assets by current liabilities. Measures the ability of the company to meet its short-term obligations. A value of 1 indicates that the company is liquid enough to sustain itself during times of turmoil.
• Quick Ratio: Measured by dividing the quick assets by the current liabilities. Emphasizes the most liquid assets (except the inventory). A higher quick ratio interprets a better capability to cover short-term obligations without relying on the slow-moving inventory.

2. Leverage Ratios: This ratio depicts how much the company owes and can be represented in two forms.

• Debt-to-Equity Ratio: Measured by dividing the total debt with shareholders’ equity. A greater ratio indicates higher leverage but also is exposed to financial risk.
• Interest Coverage Ratio: Measured by dividing operating income by the interest expense. A higher ratio indicates that the company is able to meet its debt services without any obstacles.

3. Profitability Ratios: This ratio represents the amount of profit earning capacity of the business.

• Gross Margin (Gross Profit/Net Sales): This gross margin represents the amount of revenue generated after deducting the cost of goods sold. The higher the value, the better.
• Net Profit Margin (Net Income/Net Sales): This ratio is the profit percentage obtained from sales. The higher the value, the more profitable the company is.

4. Return Ratios: This group of ratios depicts the returns the business is able to generate from its operations.

• Return on Assets (Net Income/Total Assets): The efficiency of the company in generating profit is considered here. If the value is high, then it means that the company is able to use its assets in a more efficient way.
• Return on Equity (Net Income/Shareholders’ Equity): This measures the profit generated using the investments made by the shareholders. Effective use of equity capital is represented by a higher return of equity percentage.

These are some of the major ratios that investors, shareholders, analysts, and management use to interpret the health and position of the company. There are more ratios that represent the efficiency and effectiveness of running the business.

A balance sheet is one of the significant financial documents which states the financial well-being of a company or business. It is a part of the financial statements that include the balance sheet, income statement, cash flow statement, and statement of retained earnings. The balance sheet consists of the company’s assets, liabilities, and shareholders’ equity considered for a specific period. It depicts the total assets of a company and how these assets are being financed (via debt or equity). The balance sheet is updated timely based on the company’s standards and government policies. The investors rely on the balance sheet to understand what the company owns and owes. Further, the balance sheet serves as the key to financial modeling and accounting.

Geeky Takeaways:

• The balance sheet is a financial statement depicting the worth of a company based on the assets, liabilities, and shareholders’ equity. In other words, a balance sheet is a statement of net worth or a statement of the financial health of a business.
• The basic formula applied to the balance sheet is Assets = Liabilities + Shareholders’ Equity.
• It gives a summary of the financial position of a company and displays the amount the company owns and owes.
• The net worth is the book value of the company and the date or time period on which the assets and liabilities of the company are tallied is known as the reporting date.
• The balance sheet is divided into two categories: Assets (current and non-current assets) and Liabilities (current and non-current liabilities). Here, the non-current assets or liabilities depict the long-term assets or liabilities.